Should You Take a Look at Vector Group?

Vector Group is the fourth-largest publicly-traded cigarette company in the United States, but does that mean it's worth investing in?

Most investors are well aware of the four main public tobacco companies which have their primary listings in the United States: Altria(NYSE:MO), Reynolds American (NYSE:RAI), Philip Morris International, and Lorillard. Philip Morris International is not active within the United States and Altria, Reynolds, and Lorillard control most of the domestic cigarette market. However, there is a fourth listed domestic cigarette company: Vector Group(NYSE:VGR).

Vector manufactures and sells cigarettes through its Liggett Group and Vector Tobacco subsidiaries under the Pyramid, Grand Prix, Liggett Select, and Eve brands. The company is the fourth-largest publicly listed tobacco company within the United States but it only has a tiny share of the market. Indeed, Vector's tobacco sales are minuscule in comparison to those of its larger peers. For the fiscal third quarter the company reported tobacco revenue of $274 million and gross income of $77 million, up 10% year-over-year.

In addition, to highlight Vector's tiny share of the domestic tobacco market, the company recently reached an agreement with the US government which allowed it to postpone making tobacco settlement payments until the company's market share of the domestic cigarette market exceeds 1.65%.

That being said, current trends within the domestic cigarette market indicate that Vector may snatch market share away from its peers faster than expected.

Numbers reveal trends Data supplied by Reynolds within a shareholder presentation at the end of last year shows that 'down-trading' is taking place within the US' domestic cigarette market. Reynolds noted that since 2006, the number of premium cigarettes sold as a percentage of the overall volume of cigarettes sold within the United States has declined from just over 70% to 58.6%. Meanwhile, sales of value cigarettes now account for 41.4% of the total market, up from just below 30%.

What's more, Reynolds reports that the markets for pipe and roll-your-own tobacco, products that generally result in lower costs per equivalent cigarette, have exploded over the same period. For example, annual sales of pipe and roll-your-own tobacco rose from 20 million pounds in 2006 to an estimated 41 million pounds for the full year of 2013.

Reflect in results This trend is actually reflected within the results of both Philip Morris and Altria. Specifically, Altria reported that in the nine months ended Sept. 30, the volume of Marlboro cigarettes shipped by the company declined by 3.8%. Meanwhile, the volume of 'value' brands shipped by Altria in the nine months to Sept.30 rose by 5%. Still, discounted cigarettes sold by Altria only accounted for just under 10% of the total volume of cigarettes sold by the company during the first nine months of last year. The rising number of value cigarettes sold by Altria has gone some way toward offsetting the falling number of premium-price Marlboro cigarettes sold by the company.

However, this trend has not carried through to Reynolds' product offering, which is of some concern considering that the company believes that its Pall Mall brand of cigarette is, and I quote, "a quality cigarette at an affordable price." Despite this belief, sales of Pall Mall declined 1.3% in the nine months ending Sept.30. Nevertheless, this was still better than the industry average decline, which was reported at -6.3%, indicating that someone is losing out while Altria and Reynolds gain.

Where does Vector factor into all of this? Well, Vector produces the Pyramid deep-discount brand which gained superior brand recognition with placement in both Wal-Mart and 7-Eleven stores back during the middle of last year. With this placement and correct pricing, Vector should be able to ride the trend currently taking place in the market toward discount cigarettes.

What about that yield? Vector group currently offers a 9.5% annualized dividend yield, nearly double what its peers offer. However, the most important question is whether or not Vector can sustain this payout.

Well, looking at the company's SEC filings it would appear that the company can sustain this payout but only just barely. You see, for the nine months ending Sept. 30 Vector paid out $107 million in dividends but it only generated $55 million in cash from operations. Due to the movement of debt and the purchase and sale of investment securities, the company managed to find enough cash to pay the dividend.

During the same period in the prior year, Vector's operations provided cash of $97 million and the dividend only amounted to $100 million. So, through property asset sales, retained profits, and debt issuance, Vector has been able to maintain its lofty dividend payout for the past few years and the company looks as if it will be able to maintain this cash return in the near future.

Foolish summaryVector Group presents an interesting opportunity. The company is a play on the value section of the United States' domestic cigarette market and its impressive dividend yield looks well covered at more than double the sector's average.